Most Buying in Muni Debt Since 1993 Refutes Default Wave Specter

Individuals undeterred by the lowest tax-free yields in a generation are pouring the most money in 19 years into municipal debt, leaving local-government interest rates poised to drop further.

Buying now makes sense because coupon and principal payments will total $113 billion from June through August, eclipsing new issuance by about $20 billion and pushing bond prices higher, said Chris Mauro at RBC Capital Markets.

A slowdown in defaults and an improving state fiscal outlook are also making munis a haven amid concern that Europe’s sovereign debt crisis is deepening. Investors have added $11.4 billion to U.S. municipal mutual funds this year, the best start since 1993, Lipper US Fund Flows data show.

“There is this cycle where we all keep getting money and we’re all chasing after the same things,” said Daniel Solender, who manages $16 billion of munis at Lord Abbett & Co. in Jersey City, New Jersey.

The wave of purchases is a reversal from a year ago. During the same period of 2011, individuals pulled $21 billion from local-government mutual funds, the most since at least 1992. The withdrawals followed a December 2010 interview with Meredith Whitney on CBS Corp.’s “60 Minutes” in which she forecast “hundreds of billions of dollars” of defaults in 2011.

Fiscal Stability

Instead, states’ tax collections have exceeded levels from before the 18-month recession that ended in June 2009 and more than half project cash surpluses to end their budget years, boosting investor confidence. Twenty-one issuers have defaulted for the first time this year, compared with 29 in the same stretch of 2011, according to a May 1 report from Municipal Market Advisors in Concord, Massachusetts.

Munis have been a safer bet this year than company bonds, Treasuries, commodities and stocks.

After adjusting for volatility, local-government bonds have earned 1.8 percent since Dec. 31, to 1.1 percent for corporate debt, 0.8 percent for the Standard & Poor’s 500 index, 0.1 percent for federal securities and 0.03 percent for commodities, according to data compiled by S&P and Bloomberg through May 10.

“If you look at tax-equivalent yields, they look attractive versus other fixed-income markets,” Solender said. “The returns look good too. People see the returns and want to participate.”

Taxable Equivalent

The Federal Reserve’s policy of keeping its key lending rate near zero has helped cap Treasury yields, making the tax- exemption of municipal bonds more attractive.

The 1.77 percent yield on top-rated munis maturing in 10 years is equivalent to a 2.72 percent taxable rate for investors in the top income bracket.

Municipalities from Los Angeles to Bangor, Maine, have taken advantage of the dropping rates to refund debt. About 60 percent of the bonds sold this year by cities and states has been for refinancing, the highest ratio since at least 2007, data compiled by Bloomberg show. That limits the growth of municipal debt outstanding.

“The greater amount of refunding activity we have, the more reinvestment pressure it puts on the market,” said Mauro, RBC’s head of U.S. municipal strategy in New York. “That will keep muni rates and ratios the way they are, or potentially drive them lower.”

Munis aren’t as attractive as they were earlier in the year. Ten-year yields fell to about 95 percent of those on Treasuries last week, the lowest ratio since April 3.

Payments Ahead

Coupon redemptions and principal payments are set to total $38 billion in June, $42 billion in July and $33 billion in August, Mauro said. Issuance in those months may average $30 billion, he said.

The yield on 20-year general-obligation bonds fell the past five weeks, to 3.71 percent, according to a Bond Buyer index. It’s the longest rally since June and close to the Jan. 19 rate of 3.6 percent, the lowest since 1967.

“We’ve got these continued flows, huge coupon and principal payments coming up, and a calendar that’s manageable,” said Mauro. “It sets the market up for a very strong technical environment.”

The risk-adjusted return is calculated by dividing total return by volatility, or the degree of daily price variation, giving a measure of income per unit of risk. The returns aren’t annualized. Higher volatility increases the prospect for losses.